Thoughts from economist Mark Zandi, "Y2K One Last Time" (long)

"A testimonial to the economy's fundamental strength has been its ability to easily shrug off one economic shock after the next. The most recent and notable has been the global economic crisis. Approximately one-half of the global economy is currently in or near recession, yet the U.S. economy could not be performing better.
Perhaps the most discussed, but least understood potential shock that could be serious enough to put an end to the current stellar economic times is Y2K. Y2K refers to the potential failure of computer systems beginning when the clock strikes midnight on New Year's Eve 2000. The problem, simply put, is that computer software that manages information and data for many critical business and government systems cannot handle the change over in dates that will occur. Many systems will fail because they will read the short-hand 00 used in software as 1900, not 2000. Equipment with so-called embedded processors may also fail for similar reasons. Equipment with such processors range from cars and washing machines to sophisticated instrumentation in manufacturing processes. Some well-respected economists believe that Y2K will result in a more serious global downturn and even an U.S. recession.

What will be the economic impact of Y2K? Three alternative scenarios are considered.

The most likely Y2K scenario is that it will have only a very modest disruptive impact on the U.S. economy. This scenario is given a very subjective 60% likelihood of occurring. The appropriate analogy would be that Y2K's economic impact would be similar to that of a global earthquake. Some parts of the world may experience tremors equivalent to 6.0 on the Richter scale (e.g. Russia), while other part of the world will experience only minor rumblings (e.g. United States).

This scenario is supported by an assessment of the Y2K compliance efforts in the industries that are necessary to the broader functioning of the economy. These industries include financial services, the government, the electric utility industry, telecommunications and the transportation industry. A failure of the computer systems in one or more of these industries for an extended period could indeed have significant economic repercussions.

The financial system, perhaps the most important to a well-functioning economy, appears well on track in its Y2K efforts. Regulators, including the Fed, FDIC and OCC are carefully monitoring banks under their supervision and have a careful timetable for Y2K preparedness. In their latest report card, the FDIC cited less than 1% of the over 6,000 institutions that it reviewed as having achieved "unsatisfactory" progress in their efforts.

The economy would be at risk if key government systems fail. While the federal government is struggling more than financial institutions to become Y2K complaint, many eyes are watching and significant resources are being devoted to the problem. The federal government's Y2K efforts are documented quarterly by the Office of Management and Budget. In its latest report completed in February, the OMB found that of the 6,400 computer systems deemed to be critical to the functioning of government, 79% are currently Y2K complaint. This is up from 61% in November, 50% in August and only 27% a year ago. The government appears to be successfully accelerating its remediation efforts and will be largely Y2K compliant in time.

The electric power, telecom and transportation industries are also making quick progress in becoming Y2K compliant. The North American Electric Reliability Council, which is coordinating Y2K preparation across the U.S., Canada and Mexico, reported to the Department of Energy earlier this year that Y2K would have a minimal impact on electric system operations in North America. The FCC has confirmed that the major U.S. telecom carriers are well along in their remediation efforts, although smaller carriers still lag behind. The airlines and airports also appear to be nearing compliance. Boeing indicates there are no Y2K problems with its planes.

All of this is not to suggest that Y2K will not have an impact on the economy. There are bound to be some disruptions. Moreover, the costs of resolving Y2K issues have also already become a significant financial burden on many businesses and governments. The federal government recently estimated that Y2K remediation will cost it over $6 billion. Even this may be underestimating the costs, since a year ago the government thought Y2K would cost less than $5 billion and two years ago it thought it would cost only $2 billion. Assuming that the federal government's Y2K costs are proportionately the same to its size as for other businesses, then the cost of Y2K remediation for the entire economy will be near $100 billion.

Y2K is also affecting the timing of economic activity. Businesses appear to have accelerated their investment spending in preparation for Y2K. Investment soared late last year as businesses wanted to get new equipment early enough to ensure that it was Y2K ready. Businesses are thus expected to slow their spending this year, which will contribute to the anticipated weakening in overall economic growth. There is some indication this is already occurring. PC manufacturers and resellers are warning that business PC sales have recently turned soft.

Inventory adjustments will also support the economy's growth at the end of this year and constrain growth early next. Manufacturers and retailers have worked hard over the past quarter century to reduce the amount of inventories they hold relative to sales. The inventory-to-sales ratio for all businesses is currently hovering near a record low. This has largely been accomplished through significant improvements in inventory management techniques such as so-called just-in-time manufacturing. Just-in-time requires that suppliers deliver their products to their customers when needed. Since many manufacturers may be somewhat wary of the Y2K compliance of their suppliers, they may decide to break temporarily from just-in-time and stockpile necessary supplies. This stockpiling would occur later this year and lift the economy's growth, but it would reduce growth early next year as these same businesses work off the unwanted inventories.

This is when the economy would be most vulnerable. Not only would inventories be somewhat bloated and business and consumer confidence fragile, but if there is to be an unexpected Y2K shock, then this is, of course, when it would occur.

An alternative Y2K scenario is that it will result in a global recession next year that the U.S. economy will be unable to avoid. This scenario is given a 20% likelihood of occurring. The analogy used by proponents of this view is that the economic impacts of Y2K will be similar to that of the OPEC oil crisis in the early 1970's. Just as oil is a key input into the global economy, so the analogy goes, is information. If the supply of information is disrupted, then many economic activities will be at best impaired and more likely come to a complete stop.

The appeal of this scenario is that so much will not be known about Y2K until it actually occurs. There could be Y2K problems that shut down vital parts of the global economy for an extended period of time. Although unlikely, it is possible, and thus this scenario can not be completely discounted.

The greatest uncertainty surrounds the potential that computer systems will fail overseas. The information technology consulting company Gartner Group estimates that Y2K readiness varies considerably from nation to nation. They have categorized nations into four levels of readiness. The U.S., Canada, the U.K., Australia and Scandinavia are not surprisingly the most prepared. These are category I nations, meaning that only approximately 15% of companies will suffer at least one mission-critical failure. Asian nations are in general thought to be the least prepared, being placed in category IV, meaning that two-thirds of Asian companies are expected to experience a Y2K-induced failure. There are some surprises. Germany was placed in category III, meaning that one-half of German companies are expected to suffer a failure.

Significant Y2K failures overseas could disrupt global financial markets, trade, investment and travel, which in turn would put the U.S. economy at risk. If these failures are serious enough, then an U.S. recession could ensue.

Given how unprepared the rest of the world appears to be, why is the probability of an U.S. recession deemed to be so low? The recent global economic crisis is one reason for comfort. The crisis has demonstrated that the U.S. economy benefits in various ways when the global economy is struggling. Most importantly, there is often a flight-to-quality into U.S. stock and bond markets. Fearful global investors may very well take refuge in U.S. securities until it becomes clear how Y2K unfolds. This would result in lower U.S. interest rates and higher stock prices. The dollar would also strengthen, resulting in lower import prices, and a recessionary global economy would reduce oil and other commodity prices. All of this would, in turn, constrain U.S. inflation and support a stronger U.S. economy. A Y2K-excerabated recession overseas may thus have as small an impact on the U.S. economy as the recent global crisis.

Moreover, for Y2K to induce an U.S. recession, any disruptions would have to undermine business and consumer confidence. Business and consumer confidence is very resistant to temporary disruptions such as those caused by a natural disaster. They realize that while any inconvenience caused by the disruptions may not be short-lived, they will be temporary. For Y2K to undermine confidence, businesses and consumers would have to believe that the Y2K problems could not be fixed in a relatively short order. While possible, this seems unlikely, given the nature of the preponderance of potential Y2K problems and that U.S. and foreign governments would likely quickly provide emergency support for anyone that is severely affected by Y2K.

Instead of an U.S. recession sometime in the coming year, it is plausible that Y2K could stimulate a more quickly expanding economy. This would further exacerbate already tight labor markets, foment wage pressures and inflation concerns, and ultimately result in quickly rising interest rates. The greatest risk to the U.S. economic expansion in this scenario would not be early next year due to global Y2K disruptions, but late in 2000 or early in 2001. Like the Y2K recession scenario, this Y2K overheating scenario is given a 20% likelihood of occurring.

The Y2K overheating scenario begins with a much stronger economy this year than is currently anticipated. Instead of pulling back on their investment in coming months, businesses continue to invest aggressively. Businesses feel that they are sufficiently Y2K-compliant and they must invest and expand in order to maintain their profitability in the face of rising competitive pressures and costs. Businesses do prepare for Y2K by stockpiling inventories as the year-end approaches.

The U.S. economy is also boosted this year by a more significant flight of foreign investors into the U.S. stock and bond markets than is currently expected as Y2K concerns rise significantly overseas. The resulting lower interest rates and higher stock prices support continued robust housing activity and consumer spending. Consumers also stockpile goods and cash as the year-end approaches.

Despite the strongly expanding economy and a further tightening in labor markets, the Federal Reserve fails to respond by tightening monetary policy. Policymakers are uncertain about the severity of Y2K disruptions and decide not to place the burden of higher short-term interest rates on the economy jut prior to Y2K. In fact, the Fed increases the currency in inventory by about one-third as planned in order to meet the anticipated increase in cash demands.

The U.S. economy racks up another year of 4% plus growth in 1999, instead of the close to 3% growth currently expected. The jobless rate falls below 4% by year's end under this scenario and already accelerating labor costs accelerate further.

Now suppose that Y2K comes and goes, but there are only very minor disruptions not only to the U.S. but the entire global economy. While there is a drag on the U.S. economy from businesses and consumers working off their stockpiles and financial markets dealing with an unwinding of foreign investments, this is offset by the impacts of a rebounding global economy. Energy and commodity prices rise with global demand and import prices stop falling as the value of the dollar comes under pressure. U.S. inflation accelerates.

Because the Fed failed to respond to signs of an overheating economy in 1999, policymakers are forced to tighten even more aggressively in early 2000. Substantially higher interest rates results in a struggling economy by late 2000 or by early 2001.

Y2K is the next significant hurdle for the U.S. economy to overcome. The most likely outcome is that the U.S. economy will largely shrug off its impacts much like the other shocks it has had to endure since this expansion began eight years ago. Like any natural disaster, Y2K will cause disruptions and various industries and various regions will suffer. But like a natural disaster, businesses and consumers will be able to look through any problems, deem them to be temporary, and thus not significantly curtail their investment and spending. Even if the global economy sinks further into recession as a result of Y2K, the U.S. economic expansion will not falter. It will celebrate its ninth birthday this time next year, and become the longest in the nation's economic history."

If every one of Zandi's rosy assumptions turn out to be true, then his
conclusion is probably correct. The trouble is, they can't be. Nobody
disputes that Y2K preparation of much of the rest of the world is
seriously late and will not be completed and total infrastructure
collapse will occur in some countries.

Those countries will cease
to be importers or exporters for an indefinite period. That can only
be detrimental to the US, even if we miraculously are otherwise
unaffected. If those imports are oil, it quickly becomes a
crisis.

Zandi doesn't discuss this. For him, "the future is so
bright, he has to wear shades."

Mr. Decker, DREAM ON, when the dividend yield on the S&P500 stands at 1.2% and with ALL of the S&P500 earnings combined represents less than a 3% yield we are in the most massive BUBBLE economy in the history of the world.

This so call great economy is fueled by the stock market MANIA and the paper wealth it has created. This bubble will burst with or without y2k. Look out below!!

Further explain "total infrastructure collapse will occur in some
countries". How do you know this? Is your crystal ball any better
than mine?

That's the point in the article. The global outlook is already bleak
and we didn't notice. Russia is already depressed; they can't get
heat now for their cold winters. A collapse in Russia will be like
feeling a pimple on an elephant; we won't notice it.

The current Russia status is being "massaged" and "managed" by the
IMF so that they do not have to default on their loans. IMF is,
effectively loaning them their next loan payment, about every 3
months. This is pretty much so that the foreign banks can still call
their Russian loans performing.

"The last article I read on "Dismal" put the market at about 20% overvalued. (It may have been Zandi who wrote the piece.) I think we'll see a correction at some point, but who knows when or how much? "

On what basis is the market 20% overvalued?

Correction is a pleasant term but I think BEAR Market would be more suitable.

Mark's research seems thinner and thinner each time I read over this.
Blame it on the intern or research assistant, I say. Mark Zandi IS the
intern?! Oops! Well, I shouldn't have been surprised at all. (grin)
The available facts do not justify his conclusions (nor do they
justify Gary North). An opinion is not impossible, but it IS risky.
Professionally speaking. And how did he arrive at these percentages?!
(Stan grabbing numbers out of air: "Anyone need 53%? How about 29%?")

Significant Y2K failures overseas could disrupt global financial
markets, trade, investment and travel, which in turn would put the
U.S. economy at risk. If these failures are serious enough, then an
U.S. recession could ensue.

I think flight-to-quality will keep the U.S. propped up for awhile.
There are valid concerns about the global supply chain, though. There
is a limit to what flight-to-quality can do for the U.S.

Mr. Poole... since I'm a busy man, actually getting paid to report on
the Y2K problem, I will have to meet you halfway. I won't just post
a link, but I will copy-and-paste from a U.S. Dept. of Commerce
report, and post the link at the end. I trust that is sufficient?
scott
--
Transportation Modes
The efficient and reliable transportation of goods among countries
and from port to customer within countries is critical to the trading
system. The global transportation infrastructure includes airlines,
shipping concerns, railroads, and trucking companies; these are
operated by a wide variety of small and large entities. Especially
important are the air cargo and maritime shipping sectors, which
include customs facilities, cargo terminals, freight forwarders, and
distributors, most of which depend on computer systems and embedded
chips. Traders make extensive use of electronic data interchange
(EDI) to transmit customs information, letters of credit, bills of
lading, ship manifests, and other important documentation.

Shipboard systems can have as many as 100 to 200 embedded microchips
that control everything from navigation to refrigeration. In 1998,
the U.S. Coast Guard surveyed marine manufacturers and discovered
that over 20 percent of the embedded chips tested were not Y2K
compliant. Computer programs for engine automation systems that
monitor the time between required engine maintenance are a good
example of the Y2K problem. If these programs misread "00" as the
year 1900 instead of 2000, they may conclude that 100 years have
elapsed since the last engine maintenance was performed and respond
by shutting down systems to avert engine damage.

Port facilities and marine terminals could be vulnerable because of
the many systems that are time dependent: fire detection systems,
cargo tracking software, process flow controls for oil and chemicals,
temperature controls, and alarms. Date sensitive sensors could cause
an automatic shutdown response, which could trigger other fail-safe
responses downstream. In addition, there is currently no established
convention for setting time in microchips when they are manufactured.
Chips manufactured in Asia may be running at Universal Coordinated
Time (UCT) plus eight hours, whereas microchips manufactured in the
United States may be running at UCT minus five hours. For safety
reasons, some ports and offshore operators have announced that they
may suspend operations for several hours around midnight on December
31, 1999. Key seaports, canals, and waterways with large shipping
volumes represent potential transportation bottlenecks, and the
effects of Y2K breakdowns in these commercial hubs could be
amplified. Table 2 lists the world's busiest seaports, the top three
of which are in China, Singapore, and Taiwan.

Air transport is another critical link in the international trading
system. In the United States, the airlines now carry the same amount
of exports (measured in terms of value) as maritime companies. Air
transport is used particularly for the shipment of medical products,
scientific instruments, telecommunications equipment, and computers.
Y2K-related breakdowns in air traffic control or other airport
computer systems could disrupt passenger and cargo movements at
individual airports, as well as at any other airport serving them.

International trade consists of a broad array of commercial interests
and relationships that involves most product and service sectors, the
orderly conduct of which depends upon a smoothly functioning trading
system. This in turn relies on a global web of critical services.
Disruptions in the relationships among the suppliers and customers
and their overseas business partners can seriously affect the well-
being of individual companies, specific industry sectors, or even
economies in general. [emphasis mine] The Year 2000, or Y2K,
problem refers to the computers, software programs, data and
communications networks, databases, and embedded electronic devices
that lack the capability to process dates beyond December 31, 1999.
Y2K failures in electronic systems and devices have the potential to
cause supply and service disruptions. This report discusses the scope
of interdependence in the world trading system and the importance of
trade to economic interests. It does not attempt to draw conclusions
about the status of Y2K remediation efforts in individual
countries...

Energy Production & Distribution
The reliable production of electric power and distribution of heating
fuel by utilities around the world is fundamental to the trading
system. Fossil fuels-coal, natural gas, and oil-are essential for the
operation of most utilities. In the United States, over 65 percent of
electric power is generated by coal and gas. Utilities are highly
automated, with complex networks of generation plants and storage
areas, transmission networks and pipelines, and distribution
facilities. The ripple effects of Y2K-caused breakdowns in one part
of the interconnected transmission grid could cause failures
elsewhere down the line. Utilities also have a large number of
embedded chips in their equipment and facilities, some of which are
susceptible to Y2K mishaps, but which are time-consuming and costly
to locate and test.

Major long-term disruptions in fuel supplies can have serious
economic implications, as demonstrated by the energy crisis of the
mid-1970s. Table 1 lists the major exporters of fossil fuels to the
world in 1996. Saudi Arabia supplied 19 percent of the crude oil;
Russia, 37 percent of natural gas; and Australia, 30 percent of hard
coal. Russia supplies almost 15 percent of the total energy consumed
by Eastern Europe and 5 percent consumed by Western Europe through
the Gazprom Pipeline...

I don't know who Mark Zandi is, or Mr. Decker either, but I do know
who Ed Yardeni, the World Bank, George Soros, "The Economist," and the
Princeton Economic Institute are, and their views of where the world
economy (and probably the U.S. economy) are headed are considerably
grimmer. It's nice that Mr. Zandi thinks that Y2K will be, at most, a
6.0 on the Richter scale for the worst-hit countries; recent CIA, NIC,
and UN reports certainly suggest a considerably worse scenario. Also
see the Commerce report referenced above. Unlike Yardeni, who has
spent almost two years researching Y2K and its possible economic
implications, Zandi seems to have very little understanding of the Y2K
threats to supply chains. Indeed, Zandi's article suggests he spent
about two days "researching" Y2K.

Gee, so Germany is in some Y2K trouble? Nothing to really worry
about. Forget that last summer GartnerGroup said that German banks
were a year behind American banks in their Y2K work. Our banks have a
year to spare, right? Forget the Japanese govt. FSA report on the Y2K
status of some of the biggest Japanese banks. Forget the British FSA
Y2K report on some of the largest London banks. No sweat.

As for the U.S. specifically, even Sen. "Bump in the Road" Bennett
recently noted that an "inventory recession" was virtually inevitable
in early 2000.

So the U.S. stock market is "only" 20% overvalued? Curious,
considering that just 29 months ago, when the Dow stood almost 5,000
points lower than it does today, Greenspan was worrying about
"irrational exuberance." Curious, too, given that Yardeni's main
stock market valuation model showed the market (S&P 500 index, I
believe) overvalued by at least 29%--and that was almost a thousand
points ago, with the assumption that corporate earnings would grow at
15% this year and again next year, which nobody really expects. Hell,
even the World Bank recently called the U.S. stock market situation
"unhealthy" (especially since it is leading, not reflecting, the
U.S. economy)--but the World Bank should defer to Zandi and Decker, I
guess. So should Yardeni, even though both the WSJ and "Barron's"
have called him one of our top economic forecasters. And the
Princeton Economic Institute? Bozos, one and all. That was just a
lucky guess they made about the 1987 crash.

So don't worry about P/E ratios, folks. Don't worry about Y2K. Don't
worry that we have record consumer debt, record personal bankruptcy
rates, and the first negative savings rate in the U.S. since the Great
Depression. Americans will buy and buy and buy, because they feel
rich based on their capital gains in the stock market; such consumer
buying mania will push stocks higher; that will make Americans feel
even richer and so they will buy even more, and that will push stocks
even higher. This can go on forever. Don't you know that the circle
is the perfect artistic and economic form?

We are in a new age of prosperity where nothing can go wrong. That
was also precisely the message conveyed by most economists in early
1929. As they say, you can look it up.

Whoops! When I referred to Yardeni's estimate that the stock market
was 29% overvalued and I said that estimate came almost 1000 points
ago, I was thinking of the Dow, of course; Yardeni, who tends to use
the stock valuation model developed some years ago by the Fed for
Greenspan, customarily applies his valuations to the S&P 500 index. A
month or so ago, when Yardeni made his estimate, the S&P 500 index was
probably 50-100 points below where it is today. (The S&P 500 index,
like the Dow, has been setting new records lately.) Sorry for the
confusion--this is what I get for changing indices in midstream.

One other point re Y2K and the international scene. I often note the
argument that we need not worry that some undeveloped or developing
countries might be hit hard by Y2K; we are told that such countries
are already in sorry shape and that any additional hardship won't
really be noticed. This strikes me as a rather peculiar (not to
mention callous) line of reasoning. Leaving aside the question of
whether even advanced countries like Germany and Japan might not get
hammered by Y2K (especially in their financial sectors), I personally
don't want to see how much more trouble or downright suffering people
in Latin America, the Middle East, SE Asia, or Russia (especially
Russia!) can take on top of what they already have. So it doesn't
matter if the Russians don't have power or heat next January? After
all, it aint cold in Moscow in January. And forget what NYU Russian
expert Stephen Cohen said just a few months ago: that he fears
"apocalypse soon" in Russia (a statement made without any reference to
Y2K, incidentally). What does Cohen know? On top of everything
else, let 20% of Russian computers fail because of Y2K; let their
power grid collapse; so what? Ditto for other parts of the world. So
GartnerGroup said last week that Latin America is way behind on Y2K
and it's now too late to do any meaningful work to catch up. So what?
So what if China, with its hand-me-down hardware and pirated software,
has opened its fortune cookie and found therein "Confucius says big
Y2K trouble is coming"? Hey, the Chinese are so happy with all the
nuclear secrets they have stolen from the U.S. that nothing can upset
them these days.

And all of this on top of rather grim recent IMF economic forecasts
for Latin America, Japan, and even Western Europe.

In short, let the rest of the world go to hell in a handbasket.
Fortress America is safe. The song on Wall Street these days is "We
Are the World"--the only world that matters, that is.

And to think that some of those crazy foreigners actually think that
Americans are arrogant.

I just got back from a ballgame, so I couldn't respond to your
pop quiz until now.

I'm a newbie to this forum, but I've
ascertained that you are one of the pollyannas, and I realize I have
no chance of convincing you of anything. You're just baiting me.
That's fine. I'm looking for truth and debate helps.

BTW, I didn't
say anything about pharmaceuticals in my post, so I decline to bring
them up further now, given the nature of your challenge.

OK,
without providing links, or going back to them to refresh my memory,
my statement about oil imports goes back to the report issued to
Senator Bennett's committee wherein it stated both that the oil-
exporting nations and the maritime industry were lagging in
remediation efforts. I guess if remediation isn't important, then
that report wasn't important.

The Gartner Group lists many of the
countries from which we import oil as being woefully unprepared. If
you have information to the contrary (links welcome), I'd like to see
it.

There was a story, probably also posted somewhere in this
forum, that came out a few days ago about South American Y2K
preparedness. The cabinet official for Columbia said something to
the effect that Columbian air traffic controllers were going to have
to be trained to direct air traffic manually. With binoculars, I
guess. In the same story, the Venezualan official opined that there
could be food riots in his country. Have I remembered anything wrong
here yet?

Let's see...last report on Italy I read said that the
government had formed a Y2K committee, but it hadn't met yet--that
was in January, I think. Russia is a basket case and didn't discover
Y2K until late last year. It may be a pimple to our economy, but
last time I checked, it provided most of the natural gas to
Germany.

So, tell me, why won't the infrastructure of Russia, or
Cuba, or any of our trading partners collapse? I haven't been around
here long enough to figure out whether you think Y2K is a scam,
equivalent to a mild headache, or fixable on failure of multiple
systems within a few days. I mean, if this is a bullsh*t, tell me.
My company is budgeting $18 million for this year alone on Y2K. I'd
rather see that go to salary enhancement.

In a "normal" economy, the companies that go out of business are
the weak ones. These are not the companies with customers highly
dependent on their products. If they had such customers, presumably
they could charge enough to stay in business.

Y2K affects companies without much regard for their health or the
demand for their products. If a key foreign supplier to a Fortune 500
company is hit badly, it could either go under, or force shutdowns by
its large customers. This is a company that would normally never be
put out of business by a local recession, since it still has a healthy
US customer. It might raise or lower prices, but it would not go out
of business.

Therefore, Y2K is qualitatively different in impact from normal
economic disruptions. In that respect, it is more like a natural
disaster, which wipes out strong or weak companies indiscriminately,
rather than an economic slowdown, which preys on the weak.